Download Strong Demand for Muni Bonds Yields Pros, Cons

USA A M A R K ET COMMENTA RY — 5/ 18/ 16
Strong Demand for Muni Bonds
Yields Pros, Cons
By Regina Shafer, CFA, Senior Portfolio Manager of Tax-Exempt Investments
The good news in the municipal bond market: There is strong investor
demand, which is bidding up prices. Not only is the domestic desire
for munis running hot, the presence of negative interest rates in
developed Europe and Asia has escalated the amount of money
flowing in from overseas banks, pension funds and other institutions.
The not-so-good news? Bond issuance by state and local
governments, either to fund new projects or to refinance existing debt
at a lower interest rate, is falling far short of what’s needed to meet
this demand. The Bond Buyer, a newspaper focusing on the muni
market, reports that issuance in April was down more than 20% year
over year, marking the eighth-straight monthly decline for that metric.
This disharmony between supply and demand has driven yields on
long-dated munis down to their lowest levels in many years. This has
been a positive for the muni market’s total return. Prices and yields
move in opposite directions; the downside is that higher prices we’re
seeing now generally mean less income for investors in the future.
As long-term, income-oriented investors, we want higher yields. The
main reason is that, over time, income accounts for most of the return
on a fixed income investment. This important relationship is why we
manage our muni bond portfolios with a primary focus on long-term
income and thus why we would be happy to see higher interest rates.
KEY TAKEAWAYS
• Demand for municipal bonds
is far outstripping supply.
The result is yields being
pushed to their lowest levels
in many years.
• As income-oriented investors,
we welcome higher interest
rates, but there’s little reason
to think the Federal Reserve
will accelerate its pace of rate
hikes anytime soon.
• Our muni funds maintain an
income advantage compared
to the peer average. This
is particularly valuable for
investors in higher income
tax brackets.
But the Federal Reserve has made it clear that it plans to move
slowly on normalizing its interest rate policy out of concern that the
broader U.S. economy may be weakening. Inflation is not a problem
despite very low unemployment and rising wages, so the Fed faces
little pressure to act quickly to raise rates.
Competition for muni bonds is ferocious. These days, when new
deals come to market, it’s not unusual for demand to be 20 times
greater than the available supply. Along with their tax-exempt
income, the relative low volatility of munis is a big part of their
appeal. Markets opened 2016 with a big spike in volatility, and
while things have been calmer lately, many expect more turbulent
conditions to return later in the year.
USAA Market Commentary — 5/18/16
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MARKET
COMMENTARY
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In this challenging environment for munis, we are patiently doing what we always do. Our credit analysts
continue to scour the market for the most attractive bonds that meet our strict risk criteria. With fewer
available bonds and more competitors, the work of building and maintaining a portfolio is harder than usual,
but we are holding to our standards.
Our muni funds still have a tax-exempt income advantage compared to the peer average, which is especially
valuable for those investors in the higher tax brackets. (Past performance is not a guarantee of future results.)
We are not following many of our peers into more speculative securities in search of higher yield. Some
look at Puerto Rico and other places struggling to manage their debt burdens, and they see opportunity.
When we look at them, we see lots of sleepless nights worrying about whether they’ll be able to make
their next payment.
USAA INVESTMENT OUTLOOK
We are neutral U.S. large caps and underweight U.S. small caps. While signs point to continued slow
recovery for the U.S. economy, valuations are not cheap. On a comparative basis, we see better valuation
opportunities in overseas equity markets.
We are overweight non-U.S. developed markets based on relative valuations and neutral on emerging
markets (EM), as the strength in the U.S. dollar may further pressure share prices. Over the longer term,
however, we believe EM equities provide a higher expected return relative to other asset classes.
We are tactically underweight fixed income. Within fixed income, we prefer areas of the market that are
more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate
bonds and high-yield bonds.
We are neutral to assets that are positively correlated to inflation, given reduced expectations for inflation
over the medium term.
As always, we encourage investors to speak with one of our financial advisors, who can help determine
which investment vehicles are best suited for you based upon your individual goals, objectives, risk
tolerance and time horizon.
USAA Market Commentary — 5/18/16
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USAA Market Commentary — 5/18/16
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